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Equity Markets Rightly Take Trade Wars in Stride

(Bloomberg Opinion) -- Financial markets are taking the escalating trade conflict between the U.S. and China in stride. Instead of sending stocks reeling, investors have pushed the S&P 500 Index to within 0.7 percent of the record high of 2,873 reached on January 26. Are investors too complacent?

Market participants should be prepared for the possibility that while the trade wars will have many sector specific casualties, there will be winners as well. The net impact, while negative, might be swamped in the scope of the U.S. economy.

For instance, although there are scattered reports of tariff-associated layoffs, overall initial jobless claims remain low. If tariffs begin to exert a strong negative impact on the economy, not only should jobless claims rise, but there should also be a wide dispersion of rising claims across all the states. Another leading indicator, temporary help employment, continued to climb in July, a pattern that typically foreshadows further aggregate job growth. These are things to watch as warning signs that tariffs are sapping the U.S. economy, but they have yet to reveal any weakness.

Despite the higher costs of steel and other inputs due to tariffs, manufacturing employment continued to rise in July. Firms added 327,000 workers over the past year -- and they want even more workers. The manufacturing sector had 482,000 job openings in June, a cycle high eclipsed only by the 496,000 openings recorded in January 2001. The sector continues to build on the momentum of the underlying economy rather than succumbing to the weight of tariffs.

Of course, it may simply be too early to see any widespread impact from the trade wars. But it seems more likely that we would see limited macroeconomic impacts from the initial round of tariffs because they are simply a relatively small hit to the economy. Even assuming the next tranche of threatened tariffs become reality, a 25 percent tariff on $50 billion of goods is just $12.5 billion. Although that’s not a small sum of money to any one person, in the scope of a $20 trillion economy it is barley a drop in the bucket.

And that gets to a bigger issue. One reason for not expecting a large negative is that trade is the tail of the U.S. economy, and the tail doesn’t wag the dog. A 25 percent tariff on the entire $500 billion of goods imports from China is like a tax of $125 billion on U.S. consumers – but that amounts to just 0.6 percent of the entire U.S. economy.

For more perspective, consider that Nobel laureate Paul Krugman estimates that the welfare loss of a full blown global trade war would be just 2.1 percent of U.S. gross domestic product. Similarly, according to the Center for Foreign Relations, the gains from North American Free Trade Agreement may amount to less than 0.5 percent of GDP. And the Peterson Institute for International Economics estimated that the now-defunct Trans-Pacific Partnership would only add 0.5 percent to U.S. incomes by 2030.

These estimates suggest that the net impact of freer trade, while positive, are fairly small. This, of course, hides substantial industrial reorganization in the background. There will be winners and losers in a trade war, just as there were winners and losers when tariffs fell. To be sure, the gains and losses to firms, individuals, and communities tend to be very concentrated. Think of the current hit to U.S. farmers. But they largely wash out in aggregate such that the net benefits or costs are small and spread thinly across the population. This doesn’t mean that freer trade doesn’t make us better off or that trade wars don’t have consequences – they do. But the magnitude of gains from trade agreements such as NAFTA look smaller than the hype would suggest.

So while we should be watching for negative impacts from tariffs, we should also keep in mind that there may be little to see in aggregate. Market participants thus might be entirely rational in pushing stock prices higher despite the trade disputes. Watch instead for sector and firm specific gains and losses with higher tariffs while expecting the broad contours of the business cycle to continue to be driven by domestic factors.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.